Two two-trillionaires

The Fed’s balance sheet just surpassed 2 trillion dollars. It has grown by a trillion dollars over the course of the year. Literally. See “total factors supplying reserve balances” at the close of business on October 29. That growth was financed by Treasury bill issuance ($560b from the supplementary financing facility) and a large rise in banks deposits at the Fed ($405b).

The stated foreign reserves of China’s central bank reached $1.9 trillion at the end of September. That though understates the total assets managed by the PBoC by around $200 billion. It is now clear – I think – that the PBoC manages about $200 billion in foreign currency that the state banks have placed at PBoC. This isn’t a secret: the PBoC reports over $200 billion in “other foreign assets.” That means the PBoC already has a foreign currency balance sheet of over $2 trillion.

The pace of growth in that balance sheet slowed a bit in q3 – and may slow more in q4. But between q3 07 and q3 08, the PBoC added about $600 billion to its foreign portfolio (and another $100b or so was handed over to the CIC). The CEQ summary of my article for them covers this — though it only goes through q2 2008.

It consequently is natural to compare the balance sheet of the Fed with the external balance sheet of the People’s Bank of China — a balance sheet that is managed by the State Administration of Foreign Exchange (SAFE).

The Fed has a somewhat under $500 billion in Treasuries on its balance sheet. But it has lent about $220 billion of those securities to liquidity starved broker-dealers. It consequently has fewer Treasuries on hand than it reports. Its “uncommitted” Treasury portfolio is around $270b.

SAFE has – if it is safe to assume that SAFE accounts for the majority of China’s reported holdings of Treasuries – about $540 billion of Treasuries. But this total understates China’s real holdings; China probably accounts for about ½ (maybe more) of the Treasuries sold to investors in the UK (look at the pattern of past revisions). It consequently has more Treasuries on hand than reported in the US data – probably about $700 billion.

The Fed has provided about $1 trillion in credit — ok, $920 billion — to the US financial system – whether repos ($80b), term credit ($300b), other loans ($370b), purchases of commercial paper ($145b), or its holdings of the Bear assets JP Morgan didn’t want ($27b now).

Basically, the Fed is currently “funding” an awful lot of the US financial sector –

So too is SAFE.

Adding China’s purchases of Agencies since last June to its reported total in the last survey implies that China now has about $450b in Agencies – down a bit from its peak. No doubt it will come down more (the Fed’s custodial data indicates an ongoing shift out of Agencies by central banks, and the still-high spreads on long-term Agencies are widely attributed to a lack of Asian demand). On the other hand, China’s total Agency portfolio is underreported in the US data – based on the pattern of past revisions, Arpana Pandey of the CFR and I estimate that China’s Agency holdings peaked at around $575b – and have now fallen to around $550-540b.

The Agencies, lest we forget, are financial intermediaries. But they generally have a higher quality mortgage portfolio than private financial institutions, so the underlying risk here arguably isn’t as high as the risk on the Fed’s balance sheet. In some sense though it doesn’t really matter now that the Treasury has indicated it won’t allow systemically important financial institutions to fail: in both cases though the ultimate guarantor against losses is the US Treasury.

SAFE likely has extended some credit to US financial institutions as well – whether by buying their bonds or investing in short-term money market funds that hold some of their paper. I would estimate this exposure is in the $50-100b range – but this is very much a guess.

The Fed now has a foreign portfolio of around $540b – as it has accepted foreign currencies (mostly euros and pounds) as collateral for the dollars it lent to foreign central banks through its swap lines. The structure of these swaps though implies that the Fed has little foreign currency risk; other central banks will eventually pay the Fed back in dollars, and the Fed will hand the foreign currency back.

I suspect that somewhere between 30% and 40% of SAFE’s portfolio is also in reserve currencies other than the dollar (mostly euros, yen and pounds). That works out to a total of between $630b and $840b. SAFE’s non-dollar reserve portfolio would be the world’s second largest reserve portfolio if managed on a stand alone basis. Unlike the Fed, SAFE has the currency risk, for better (2002-q1 2008) or worse (q3 2008, October …)*

All in all though their respective balance sheets look fairly similar. It is almost scary.

They even each likely have a somewhat toxic portion of their portfolio. SAFE is widely thought to have been given permission to put around 5% of its portfolio in equities at some point in 2007. That implies that it likely bought close to $100b of global equities before equity markets started to slide. Its losses here likely exceed the CIC’s losses on Blackstone and Morgan Stanely – at least in dollar terms. It had the bigger absolute exposure to equity markets.

The Fed is the proud owner of nearly 80% of AIG. And its holdings of Bear debt may have some equity like properties …

There are two key differences between the Fed and SAFE though.

One, the Fed has been increasing its exposure to risky assets while SAFE has been reducing its (relative) exposure to risky assets. The Fed’s Treasury holdings are going down; SAFE’s are going up fast – largely because it seems to have stopped adding to its Agency portfolio.

Two, the PBoC’s liabilities are in RMB, while the Fed’s liabilities are in dollars. That means that the PBoC has an underlying currency mismatch — and all the associated risks.

You could argue that SAFE and the Fed have combined forces to keep the US economy afloat over the past year. SAFE financed the lion’s share of the United States external deficit – and did most of the heavy lifting earlier in the year when private investors didn’t like the dollar. The Fed’s financing has kept the US financial sector afloat. That incidentally is something that financial sector executives might want to consider as they award bonuses; many financial firms would have failed and not been able to pay anything absent taxpayer support –

On the other hand I would argue that the US shouldn’t give to much credit to SAFE for helping to stabilize the dollar earlier in the year – and for providing the US subsidized financing that has helped keep US borrowing rates fairly low. Why – because a lot of the vulnerabilities that built up in the US economy between 2003 and 2007 can be linked – in part – to large purchases of dollars by SAFE during that period. Holding the RMB down discouraged investment in tradables, and encouraged investment in non-tradeables (think homes). And the rise in China’s surplus even as the oil exporters surplus was growing implied large offsetting deficits in the US and Europe – deficits that were found in the US household sector.

The global implications of misaligned exchange rates is something that I hope will be on the agenda on November 15th. But I am not holding my breath …

There is more consensus globally on the need to reform financial regulation in the US and Europe (and to expand the IMF’s lending capacity) than on the need to reform exchange rates …

*In some sense this is deceptive though, as SAFE really should focus on the value of its foreign portfolio in RMB, as its liabilities are in RMB. Or alternatively – given that it is compelled to hold foreign exchange by China’s exchange rate – a measure of global purchasing power.

45 Comments

The Chinese are very sensitive to any public pressure about their currency.

We found that the only significant “down” month over the past 8 years, where China significantly reduced their total of Treasury + Agency debt, was August 2007.
That was when the Senate passed legislation aimed at China’s “fundamendally misaligned” currency, and Secretary Paulson visited China to pressure them on the issue.

They reacted immediately to Senator Obama’s comments (made in a letter to the National Council of Textile Organizations) accusing China of currency manipulation and saying that “China must change its policies”.

Do you have a prescription for the appropriate solution for currency exchange policy, both from the perspective of what needs to be done, and perhaps as importantly, how it should be handled with the Chinese ?

P.S. Thanks for the insight that “Holding the RMB down discouraged investment in the US tradable sector, and encouraged investment in interest-sensitive sectors not exposed to Chinese competition (think homes)” – the “not exposed to Chinese competition” is key – it has been vexing trying to figure out why low marginal tax rates and easy money led to hardly ANY productive investment, as one would normally expect. I think you’ve identified a key and largely unremarked component of the SAP housing and mortgage-credit bubbles…

.

Posted by JKHNovember 1, 2008 at 5:39 pm

“Basically, the Fed is currently “funding” an awful lot of the US financial sector –“

There are still a few more assets available to buy:

Total credit market debt owed by the
financial sector is $ 16.5 trillion

(Fed flow of funds table L.3)

Posted by bsetserNovember 1, 2008 at 6:02 pm

murph — a lot of other things were also happening in Aug 07 …

Posted by MichaelNovember 1, 2008 at 7:11 pm

“Two, the PBoC’s liabilities are in RMB, while the Fed’s liabilities are in dollars. That means that it has an underlying currency mismatch — and all the associated risks.”

Do you mean risks to the PBoC or to the Fed?

Posted by RichardNovember 1, 2008 at 8:22 pm

I heard the term ‘bonded out’ the other day. I’m still trying to wrap my head around debt sterilization and how original debts and liabilities ultimately get paid off. Debtors are borrowing more and more in order to continually roll over their debts. So when and how do the debts get paid off if you don’t inflate your base currency or produce profits during a cyclical asset value downtrend? Do they eventually get ‘bonded out’?

Sorry to wander off topic a little but a lot of this two trillion has gone to sterilize debt……what ever that means exactly. Two trillion US dollars. A couple of years ago a billion seemed like a new word in the American lexicon. In the last year that seems to have become old school.

“In practice that meant that Chinese demand for US assets — with more than a bit of help from US and European banks and shadow banks — supported the low level of savings and high level of borrowing in the US household sector.”

It’s one thing to make something possible, another to make it inevitable. Is there any place for human agency in these crises?

Either money is too tempting, or the products are too complex. I just don’t buy it. But then, I’m no expert, just someone trying to understand how these decisions get made.

As I’ve said many times, it makes a great deal more sense to think of irredeemable currencies, such as dollars or RMB, as equity, not liabilities.

The definition of irredeemable currency as a CB’s liability is a historical artifact of the evolution of fiat from redeemable metallic currencies. A liability is a debt: a note that can be redeemed, possibly after some maturity. Dollars and RMB are not redeemable. They do not constitute obligations in any sense. Case closed.

This matters for the argument above, because if RMB was a liability, the PBoC would indeed have a currency mismatch. For example: suppose an RMB was a promise to pay the bearer $7, or 0.3g gold, or whatever. In that case, we could ask: is the PBoC solvent? Well, that would depend on the dollar or gold of its portfolio today. With considerable implications for RMB holders!

But since the PBoC has no liabilities, just equity, it cannot become insolvent. Regardless of exchange-rate or portfolio fluctuations. So I’m not sure the situation is really analogous to a true currency mismatch, like a Latvian homeowner whose job pays lats and whose mortgage is in yen.

(In fact, it’s not clear that if the PBoC’s reserves vaporized overnight, life for anyone in China would change at all, except of course in the case of a currency run – and the RMB is still probably undervalued against the dollar. Just as a metallic currency is not dependent on the industrial value of the metals that back it, a successful fiat currency is not dependent on the value of the CB’s assets. My demand for dollars versus other goods, for example, has nothing to do with H.4 or whatever.)

Also, it’s very convenient to think of the Fed as issuing stock to buy these assets, just like a corporate acquisition. Are shareholders being diluted? Depends on whether the Fed is getting good value for its money. Certainly the net price of all dollar financial assets has been declining considerably of late, which as a reduction in outstanding shares is certainly a good deal for dollar holders. A little dilution in base money hardly equals the gigantic antidilution (distillation?) that’s been going on in broad money.

Posted by jbossNovember 2, 2008 at 6:25 am

USDRMB:

Hot money inflows made revaluation pretty difficult.

They might go for the alternative.
Running a consistently higher inflation rate while holding the nominal peg is a revaluation in real terms.
It’s slow and for the dumber part of world finance it’s even under the radar.

There is not even a danger to price stability, if the inflation target is not too high (let’s say 6% or 8%) and reliably defended.

That’s what I think, we’re seeing already: a long term change of the Chinese inflation target, masked by “concern about growth”.

A subtle and precise manoeuvre.

Posted by mental gymnasticsNovember 2, 2008 at 6:47 am

A helpful little thought experiment might be to think about the scnario where China had not acquired lets say 1 of the 2trn in treasuries and imagine what the two balance sheets, economies, “equities” or whatever would have progressed and would look like now.

It looks almost as if Chinese and US policies were (and still are) coordinated) . That is probably only partially the case, i.e. by the US following a predictable (but unsustainable) path caused by apparent ability to ignore national budget constraints and China feeding the habit. Point is, what is China going to get in return. What will China do when as appears to be the case, the US consumer becomes a little more budget-constrained? Also: who/where are the winners and losers in China and the US in this irrational game?

Posted by black swanNovember 2, 2008 at 9:08 am

b.setser states: “But it has lent about $220 billion of those securities to liquidity starved broker-dealers. It consequently has fewer Treasuries on hand than it reports.”

By my count, JP Morgan received $213 billion, alone, since March ($40B in the Bear Stearns deal, $138B in the Lehman crash and $25B in bailout money).

Why would the Chinese acquiesce to the US Government’s currency wishes? I doubt that what happened to Japan after the Plaza Accord has been lost on the Chinese.

Posted by QingdaoNovember 2, 2008 at 9:43 am

Moldbug: Assume a Chinese exporter exchanges her dollars for rmb at the PBofC. Later she decides she needs the dollars back; are they not required to return them?

Posted by JKHNovember 2, 2008 at 12:01 pm

Moldbug,

I would argue that the right hand side of a CB balance sheet is in fact redeemable, and that an argument exists to categorize it as a set of liabilities.

E.g. 1: CB notes are redeemable. Any bank that accumulates an excess of CB notes in its vault can and does redeem them for a credit in its reserve account.

You may say that’s cheating because it only results in another CB liability. But the obligation to exchange notes for reserves is still a CB liability. The CB can’t refuse the terms of that redemption to any bank presenting these notes for that purpose. And those notes are removed from circulation (at least temporarily).

E.g. 2: Bank reserves are redeemable. This is the reverse of example 1. The CB redeems the (commercial) bank’s reserve money in exchange for CB notes.

Again, you may say that’s cheating because it only results in another CB liability. But the obligation to exchange reserves for notes is still a liability. The CB can’t refuse the terms of that redemption.

So both bank reserves and CB notes outstanding are liabilities of a CB.

You may argue further this demonstrates that CB liabilities are not redeemable but only exchangeable for other liabilities. But whether the dynamic is classified as redemption or exchange doesn’t really matter to the substance of the obligation (liability) for the CB to redeem or exchange.

So I wouldn’t accept the proposition that hard asset redemption is necessary for a liability to exist. There is a definitive CB liability in the case of flows of reserve money and notes to and from the CB balance sheet. And banks are not constrained in any way in their right to redeem or exchange either of these assets, provided that they first have them to present for redemption. So this seems like the substance of a CB liability to me.

The dynamics of CB reserve and note redemption described above are driven in the first instance by (commercial) bank customer demand for CB notes versus bank deposits, plus banks’ strategies for maintaining optimal inventory levels of CB notes. E.g. customer redemption of CB notes occurs at the (commercial) bank level, in exchange for deposit credit. This drives a knock-on process of (commercial) bank inventory adjustment and redemption at the CB level – and vice versa. The public’s desired exchange of a CB liability for a (commercial bank) liability, or vice versa, reflects a shift in liquidity and/or credit risk preference. This further reinforces the existence of a CB obligation to accommodate the public’s desire for changes in their asset mix in this way.

Technical addendum 1: The redemption facility used either way affects the level of system bank reserves. But CBs are quite capable of responding to the systemic effect of either reserve or note redemptions with standard sterilization techniques.

Technical addendum 2: The public in theory could redeem all CB notes in exchange for commercial bank deposits. This would shrink the canonical CB balance sheet down to bank reserves. Demand for redemption of notes then stops because there are no more notes outstanding. But reserves are still redeemable (for newly reissued notes) by individual banks.

Technical addendum 3: Recent Fed balance sheet expansion doesn’t change the argument. New sources of funding are mostly in the form of increases in reserves and Treasury deposits. I’ve covered reserves. Treasury deposits at the Fed are a non-issue for purposes of this discussion, in the sense that they are essentially an internal entry within what is effectively a consolidated USG/Fed balance sheet, as I think you and I have previously agreed.

All of this changes the context for your default categorization of the RHS of the CB balance sheet as equity. The substance of the equity question remains, I think, because it is effectively a larger question than the liability one.

On the one hand, it is quite possible to create a liability with embedded equity characteristics, depending on what additional risk characteristic you are trying to identify, and how you wish to conceive of equity participation in that risk. A simple liability combined with foreign currency risk or domestic inflation risk has an equity characteristic when equity is defined specifically to capture such risk.

But more than this, I would maintain that CB balance sheets do have a conventional and somewhat distinct equity type exposure for the taxpayer. In connection with this, my responses to several of your statements:

“Since the PBOC has no liabilities, just equity, it cannot become insolvent.”

We agree there’s nothing unique about PBOC for purpose of this discussion, so let’s take the case of the generic CB. First, CBs can become technically insolvent if they’re allowed to do so. But this is easily resolved at the technical level by recapitalizing them with the proceeds of a government bond issue that is purchased by the CB itself. A CB in such shape depends on the government effectively plugging the hole in whatever asset deterioration it has experienced. Chinese government bonds could replace a massive PBOC write-down in the value of US dollar reserve assets. USG bonds could replace a Fed write-down of risky credit assets.

The bond manoeuvre may seem to be merely an internal bookkeeping device. But it includes a real economic consequence for the taxpayer. The taxpayer must service the additional interest cost on government debt for a future duration which, including rollovers, is indeterminate. The value of such a claim in mathematical terms is equal to the present value of future interest payments on that debt, including the interest on rollovers of unpaid principal that may turn out to be perpetual or close enough to it.

My point is that the issue of whether or not a CB can or cannot become insolvent is a function of the government’s implicit and/or explicit backing of its capital position via taxation. This reinforces a conventional capital structure view of a CB, since it constitutes a capital backstop from the government and the taxpayer. I don’t see this as contradicting my argument that liabilities do exist.

“A successful fiat currency is not dependent on the value of the CB’s assets”.

Well, I would say that its purchasing power and taxpayer exposure may indeed be a partial function of CB asset quality. But its survival as a fiat currency won’t, provided that the government maintains its fiat power.

By bsetser
“The Fed’s balance sheet just surpassed 2 trillion dollars. It has grown by a trillion dollars over the course of the year. Literally. See “total factors supplying reserve balances” at the close of business on October 29. That growth was financed by Treasury bill issuance ($560b from the supplementary financing facility) and a large rise in banks deposits at the Fed ($405b).”

Q: re that $405bn figure. Are those “bank deposits at the Fed,” excess reserves that have returned to the Fed under the new “interest on reserves” program?

1. Senator McCain’s economic advisors are clueless. During debates, McCain twice estimated that the United States had borrowed $500 billion from China. You report that if you include US Treasuries purchased by the People’s Bank of China (PBoC) in London the total is closer to $700 billion and if you include all of the foreign exchange reserves managed by the PBoC, the total is at least $1300 billion (given your estimate that China’s $2.1 trillion of foreign exchange reserves are in dollars).

2. We agree about how the US got into this mess. I loved the paragraph that you wrote that begins, “On the other hand”, as I agree completely. Indeed, China’s policy of lending us money instead of buying our assets has surpressed investment in U.S. tradable sectors and encouraged over-investment in homes while supporting the excessive borrowing in our household sector. These are among our main points in our book Trading Away Our Future.

I was very disappointed with the part that I itallicized in the following paragraph from what you wrote:

“The Fed now has a foreign portfolio of around $540b – as it has accepted foreign currencies (mostly euros and pounds) as collateral for the dollars it lent to foreign central banks through its swap lines. The structure of these swaps though implies that the Fed has little foreign currency risk; other central banks will eventually pay the Fed back in dollars, and the Fed will hand the foreign currency back.[itallics added]”

I actually was thinking that Bernanke was doing something intelligent: (1) accumulating foreign exchange reserves in order to weaken the overly-strong dollar so that American products could better compete, (2) giving the Federal Reserve some foreign exchange that could be used should there be a run on the dollar, and (3) taking advantage of the temporarily-high dollar to make some money by buying foreign exchange.

I was about to write a nice commentary about Bernanke being the first American economic policy maker to think both long-term and short-term. I would have been wrong.

a) there is a debate over whether the japanese bubble economy and its bursting can be attributed to yen appreciation, or to the loose monetary policy japan ran after the plaza that fueled asset bubbles.

b) more importantly, the yen appreciated significantly in the 70s — without destroying japan. and china now is more like japan then … i.e. still in its catch up phase

c) China is gonna get hit with an export slowdown even in the absence of cny appreciation — and china likely had its own bubble economy in the absence of real cny appreciation as well.

What is your current estimate of the value of China’s dollar denominated portfolio?

In a comment just above, I conservatively estimated it to be “at least $1300 billion.” I got that figure from your estimate of China having $2100b in all foreign currencies. My estimate assumes that at least 62% of China’s foreign reserves are dollars.

Howard

Posted by black swanNovember 3, 2008 at 10:06 am

bsetser says: “China is gonna get hit with an export slowdown even in the absence of cny appreciation — and china likely had its own bubble economy in the absence of real cny appreciation as well.”

Good points, Brad.

Posted by DJCNovember 3, 2008 at 10:24 am

Just when the Economist pundits think the unsustainable will last forever, the system throttles to an abrupt halt. The China PBoC won’t continue to buy unlimited quantities of US Treasury bonds because they no longer can afford to. While the foreign central demand plunges, the US Treasury borrowings in 2009 will explode to $2 trillion.

Howard – my estimate would be a bit above $1.3 trillion, probably closer to 1.4 trillion. remember that the CIC has about $100b and the state banks another $150b … which implies a total portfolio of around $2.35 trillion. At least 60% of that is in dollars in my view.

The end of the post seems to have got cut off too, although I suspect that I would disagree with it!

Posted by DJCNovember 3, 2008 at 11:22 am

When I see “poor” people appearing to live a more luxurious life than myself, I don’t feel jealous. The thought that goes through my head is: Which banks or finance companies were foolish enough to loan these people the money to live this lifestyle? These foolish financial institutions will never get their loans repaid. What does bother me is that the Bush-Paulson-Pelosi Bailout of Stupid Banks will use my taxes to buy these bad loans from the foolish banks.

So, who is the fool in this scenario? The “poor” person got to drive a Cadillac Escalade for a period of time, the foolish banks got bailed out, the bank CEOs took home $30 million, and I lived within my means and footed the bill for the reckless actions of others. It appears that the fools are the honest Americans who lived their lives according to the rules. The anger is building. I don’t think the politicians running this country realize what true anger looks like. They are used to Americans being herded along like passive sheep.

The brutal necessary lesson that should have been learned is that if you loan money to people who can’t pay you back, your bank will go bankrupt. The “poor” people who made a bad decision in buying homes and cars they couldn’t afford have lost those homes and cars. The banks made a bad business decision in making those loans. The taxpayer was not involved in these business transactions. This is where Hank Paulson, Ben Bernanke and George Bush, formerly free market capitalists, decided to commit our grandchildren’s money to bailing out the horribly run financial institutions.

Our government has chosen to allow these banks off the hook for their bad business decisions at the expense of taxpayers. Rewarding bad decisions and bad behavior will lead to more bad decisions and more bad behavior. The government has made a dreadful decision that will haunt our country for generations. Now the Federal Reserve has lowered interest rates to 1% again. This is where this horrible nightmare started. The massive printing of currency throughout the world will ultimately lead to a hyperinflationary bust. The law of unintended consequences can be devastating.

yes — something happened when i was trying to fix a type o from my laptop over the weekend (using a shaky wireless connection). I did a quick patch, but I’ll have to wait til i get home to restore the full post.

Well if we follow your policies then the fool is the person that saved money in the banks.

Where do you think banks get the money to loan anyway?

Posted by DJCNovember 3, 2008 at 12:09 pm

Twofish: Well if we follow your policies then the fool is the person that saved money in the banks.

DJC: Damn right. While AIG Corporation vaporizes $140 billion plus in “Helicopter money” from the Federal Reserve with absolutely no accountability, ask the several thousand depositors at failed California IndyMac Bank that were reinbursed only 100K for their CD deposits over the FDIC limit, if the system works for “Joe the Plumber”. The honest American saver is further screwed by Helicopter Ben’s “negative interest rate” policy at the current 1% fed discount rate that is well below even the official inflation rate of 4-5%. The Federal Reserve panders exclusively to the narrow economic interests of Wall Street speculators at the expense of the overall nation’s prosperity. In the past 6 weeks, under his “No Hedge Fund manager left behind” policy, Bernanke has doubled the nation’s M-1 money supply to bailout politically-connected Wall Street banks and hedge funds. The monetary value of the US dollar Whatever happended to the monetary policy of “sound money”? Why aren’t the pundits on CNBC outraged at this misuse of taxpayer money?

Posted by DJCNovember 3, 2008 at 12:12 pm

Correction:

The monetary value of the US dollar is being trashed by the irresponsible “money printing” policies of the Bernanke Federal Reserve.

The post seems to have an end now. Maybe it is not just not realistic to expect the USA to be able to compete with China’s low labour costs in any tradable products that both countries produce. An interesting explanation for the US trade deficit that was made by Bernard Connolly at AIG (who, by the way, was predicting the present bust for longer and in more detail than anyone else I am aware of) was that US companies were withholding investment because they considered the boom to be unsustainable and did not want to get stuck with excess capacity in the inevitable bust.

Which in term fund depositors and pension funds. *YOU* are the one that wants to wipe out honest savers. Paulson and Bernanke are doing everything they can to minimize losses.

DJC: Why aren’t the pundits on CNBC outraged at this misuse of taxpayer money?

Because bailing out bank depositors isn’t a misuse of taxpayer money. Look at what China did. Do you think that China would have been better off to let the banks fail in the way that the neo-liberal Washington Consensus people suggest?

I dare say that the Fed balance sheet normally contracts annually as banknotes are redeemed in January and February.

Ultimately, banknotes do have hard backing in the form of the taxation power of the state. In other words, you can effectively redeem banknotes for real resources by paying your tax liability in banknotes. To give some ballpark figures, if US nominal GDP is about $14tn and the central government share of GDP is 20%, the roughly $700bn stock of banknotes represents just a single quarter’s tax receipts.

Posted by DJCNovember 3, 2008 at 1:20 pm

Twofish,

It is a gross criminal misuse of US taxpayer dollars to bailout private capital bondholders and shareholders. Period. AIG pension holders should be reinbursed, but the shareholders and bondholders should not receive a penny of a taxpayer bailout. The taxpayer bailout of AIG represents nothing less than gross looting and criminal behavior. AIG largest counterparty is Goldman Sachs which is receiving the largess of the US taxpayer bailout. It’s absolutely absurd that the US Treasury is sending multi-billion dollars corporate welfare checks to the business partners of Hank Paulson at Goldman Sachs and various politically-connected Wall Street Hedge Funds. It’s another example of privatizing the profits to Paulson’s cronies on Wall Street, and socializing the losses to the American people.

Nov. 3 (Bloomberg) — Commercial Aircraft Corp. of China Ltd. won its first overseas regional-jet order, worth about $750 million, from General Electric Co., as China aims to challenge Boeing Co. and Airbus SAS’s dominance of the global plane market.

GE’s leasing unit will sign a contract for 25 ARJ21-700s at the Zhuhai air show tomorrow, Zhang Qingwei, Commercial Aircraft Corp.’s chairman, said today in the southern Chinese city. The planes, China’s first regional jet, cost about $30 million each, added Chen Jin, the general manager for marketing and sales.

The GE order will raise Commercial Aircraft Corp.’s total backlog for the ARJ21 to 208, Zhang said. The plane will make its maiden flight before the end of the month, added Xue Li, Commercial Aircraft Corp.’s deputy party secretary.

Commercial Aircraft Corp. was formed in May with an initial investment of 19 billion yuan ($2.8 billion). The company is backed by various state-controlled entities including Aviation Industry Corp. of China, the State-owned Asset Supervision and Administration Commission and Baosteel Group Corp.

China has also received a total of 136 orders for the MA 60, a propeller-driven commuter plane, Miao said. Xi’an Aircraft Industry Group Co., the maker of the plane, has already delivered 34 of them, he added.

China intends to make a 150-seater aircraft to compete directly with Boeing and Airbus by 2020.

Posted by goldNovember 3, 2008 at 2:33 pm

Here’s another difference between the US and Chinese reserves: US has ~12x the amount of gold that China has, and more than any other country. The US’s gold reserves amount to something like 2/3 of its total reserves, and China’s are around 1%.

First, moving dollars around between categories of the monetary base is a technical transition which for me can be abstracted over. In equity terms, it’s like exchanging a Q share for an G share, or something. While the gears, organs and lubricants of the great dollar machine are complex and must be treated with respect, we can also just leave the skin on, I think.

First, I think we are working with two slightly different definitions of “insolvency.” Your definition (for a sovereign with a consolidated balance sheet in which the liabilities are the fiat currency) is that the aggregate market price of the assets is lower than the value of the liabilities. Call this insolvency(a).

While this is a perfectly reasonable definition, I’d argue that it does not capture the essence of the problem. For me, at the forest level, an institution is insolvent(b) if it is clearly unable to fulfill its future contractual obligations.

I would argue that, in general, insolvency(a) is a special case of insolvency(b). Therefore, if you have a situation in which you see insolvency(a) but not insolvency(b), you are at the very least in danger of grave confusion.

The Fed can become insolvent(a) and need a capital injection, as you describe. But it cannot become insolvent(b), because it cannot prevent itself from issuing new dollars. There is no sense in which it can default.

Moreover, the “capital injection” is in fact a related-party transaction that illustrates the pressing need for a consolidated sovereign balance sheet.

Why are Treasury bonds risk-free by definition (regardless of the charlatans selling US CDS?) Because the Fed has the power of fiat and can prevent default. In other words, because the Fed has issued an informal but very much valid bit of bond insurance on Treasury bonds. Treasury then sells these bonds, at par due to the Fed’s guarantee, and forwards the proceeds to the Fed. Is this a substantive transaction, or a game of three-card monte?

Note that, as the maturity of the notes sold for this capital injection approaches 0, the transaction becomes trivial. In extremis, Treasury sells zero-maturity dollar bonds (ie, dollars) in exchange for dollars, which it gives to the Fed. Ie, USG is just printing dollars for itself (issuing new shares to itself). Just like any fiat-currency issuer in history, from Kubla Khan to the Commonwealth of Massachusetts.

The fact that USG accepts its own scrip in payment of taxes or fees is interesting, but I don’t really think it changes the nature of that paper as a security.

Imagine if you went to Starbucks and they only took payment in Starbucks shares. In order to buy a latte, you have to buy 1/10 share of SBUX, or whatever, and return it to the corporate pool. Weird? Definitely. But not financially inconceivable.

Posted by credulous_proleNovember 3, 2008 at 4:29 pm

DJC:

What you see there is a patent threat to the Boeing strike workers.

I think most would consider importing Chinese aircraft most deflationary…

Posted by JKHNovember 3, 2008 at 9:00 pm

Moldbug,

I think we have some points of convergence and some differences.

First, I agree with your closing point on the broader view of the consolidated G balance sheet, including the idea that government term debt financing is effectively a form of money “sterilization”.

Next, we have a difference regarding the relevance and importance of the composition of the monetary base. I’ll return to that.

Next, the insolvency question is an interesting one. I think as you say there are two different interpretations or perspectives on it. I’ve always been more suspicious when it comes to valuation approaches rather than cash flow ones, but I’ve been assuming for some time that the conventionally accepted definition was more along the lines of type a). I’ve tended to distinguish between bank runs as “liquidity events” and insolvency as a technical condition involving negative equity evaluation. Also, I’m not sufficiently familiar with bankruptcy laws, etc. to judge the more useful interpretation.

On the CB side specifically, let me run through an example, recalling that my original point of emphasis was the existence of a particular CB liability. I’m interested in demonstrating the existence of such a liability more on the basis of principle and logic than on the basis of the probability that its existence might be tested. So I’ll test it in theory by way of an extreme but thinkable example.

Suppose the Federal Reserve, having loaded up its balance sheet with credit crisis risk, incurs a significant marked to market loss on those assets. Assume this results in type a) (i.e. capital) insolvency. USG then recapitalizes the Fed by selling it USG bonds and using the proceeds to fund a capital injection. (This is purely internal bookkeeping at this point, involving transactions only within the USG consolidated balance sheet. There is no external cash flow. It could be viewed in effect as an asset swap – bonds for capital.) (I’m not sure your implied description of such a capitalization corresponds to my portrayal here. I got the impression that you included an external capital issue instead. That shouldn’t take place as a part of the capitalization per se.)

Suppose the public for whatever reason wants to redeem its holdings of Fed notes in exchange for commercial bank deposits. (Irrationally or not, the public may be concerned about the Fed’s asset deterioration. The reason doesn’t matter for purposes of illustration.)

As per my previous comment, the public will present their notes to the commercial banks for redemption in return for credits to their deposit accounts. The banks in turn will present these notes to the Fed in expectation that the Fed will credit their reserve accounts. The full effect is a sort of run on the Fed.

This is the inflection point of liability.

If the Fed or USG are run by madmen, they may refuse to redeem these notes. What will happen? At that point, the commercial banks have issued deposit credits that are essentially invested in useless Fed notes. The notes really have no value if the public doesn’t want them and the Fed won’t redeem them. They don’t earn interest. The banks might as well write them off. The Fed in refusing to redeem these notes has technically defaulted and is insolvent in the type b) sense.

You say the Fed can’t default.

I agree.

My point is that the Fed’s liability to redeem these notes overrides the possibility of technical default or insolvency of type b).

So we assume the Fed redeems the notes. What happens then?

The new effect of Fed note redemption is that bank reserve accounts have been boosted to obscene levels for the system as a whole (even more so than recently). Fed note liabilities of some $ 700 billion effectively have been converted to reserve balances in the same amount.

These days, the Fed could simply pay interest on these excess balances. That’s the new backdoor approach to sterilization in terms of the interest rate effect (although the Fed seems to be having some problem controlling the funds rate since it implemented interest payments in September). Or it could sell its assets and shrink its balance sheet. It could sell its credit risk assets at their residual value and sell the bonds that it purchased from USG in its recapitalization into the market.

The taxpayer’s position doesn’t really change as a result of the initial issue of recapitalization bonds (an error in my previous comment). The taxpayer’s loss is due to the loss on the original CB assets, however that may be identified. Bond interest paid by USG to the Fed just increases the profit the Fed remits back to USG. Nevertheless, the sale of the recapitalization bonds to the public now changes the situation. The Fed no longer has the free funding of publically issued notes.

Thus, the internal bond interest wash becomes a net external cost if the government sells the bonds into the market – i.e. to the banks. This cost isn’t due to the original asset loss, but to the disintermediation and corresponding loss of profit for the central bank. Alternatively, if the Fed chooses to retain the extra $ 700 billion in reserve balances, that also generates a new external net interest cost.

Then, on a consolidated basis, we arrive at the point of your more general analysis of the nature of a government bond. At this point, it doesn’t matter what it’s funding, although I think I’ve demonstrated the existence of a liability at the CB level.

I’ll leave more detailed discussion of monetary base components for another time. I think the distinction is quite important and is generally overlooked. Suffice to say here, it is an interesting aspect that when the public elects to increase its mobile liquidity access (physically mobile inventory versus electronic or paper portal access), it also increases its asset credit quality (central bank versus commercial bank). And the monetary policy considerations around the two components of the base are entirely different.

Finally, you may be familiar with Warren Mosler’s writing on the subject. I wasn’t until a few weeks ago. It’s the first time I’ve seen anybody else express in print the idea that the so-called reserve multiplier actually works in reverse to its textbook portrayal. (Maybe I haven’t looked hard enough. But this is a fairly important idea as it has ramifications for related areas. For one, it more or less destroys the theory of fractional reserve banking. (FRB theory should have been destroyed anyway, since banks lend on the basis of capital underpinnings more than cash or liquidity reserves.)) He also has an interesting comprehensive operational perspective on monetary policy that draws government budgetary impacts more directly into central bank reserve management – sort of compatible with the idea of government bonds being an extension of central bank sterilization. My initial impression is that he’s on to some correct ideas and has been for some time.

Posted by derrylNovember 4, 2008 at 12:31 am

JKH,
I just read Warren Mosler’s “Soft Currency Economics” and I agree that textbooks have the money multiplier backwards: banks’ creation of loans (assets/deposits) causes the need for reserves, not vice versa. And I agree with your contention that fractional reserve banking theory misses the core principle that a bank’s capital and the assets/capital ratio, not its reserves, determine its lending capacity. Besides which, in practice CBs do not attempt to control the money supply by arbitrarily withholding cash or Fed account reserves from commercial banks. So fractional reserve theory entirely misses what is actually happening.

Someone recently pointed out that investment banks’ assets/capital ratio is flexible and determined by volatility measurements. Is the commercial bank ratio also now determined this way? Or is it still periodically reset by legislation? Or by its CB? My most recent text is from 1995 and I need an update.

The thrust of Mosler’s work is virtually identical to the work done in the 1920s and ’30s by CH Douglas who called his idea “social credit”. If you Google “money and the price system” you can read the text of a presentation he made to the King and government of Norway in 1935. It’s a concise presentation of the essentials of Douglas’ thinking.

Douglas’ basic observation is that an economy’s price system is not self-liquidating. If a business’ round of production distributes $1 million into the economy as its costs, there is only $1 million new money in the economy to recover via its prices. Profit is arithmetically impossible.

Savings further reduces the amount of earned or “owned” money in the system from which the producer hopes to recover his costs. Every other producer is in the same boat so Paul can rob Peter to earn a profit, but then Peter will not be able to recover even his costs.

Douglas observes that classical economics describes what is in fact, or is little advanced beyond, an 18th century barter economy where everybody works and produces and division of labor specializes their outputs which they trade for in-kind outputs of others. There is no “profit” in this system. I put X quantity of goods into the system and I purchase X quantity out of the system. There is no X + P in the system.

In this primitive economy money is used as a means of exchange, and the value of money behaves like a commodity value that is universally exchangeable for goods values. But in a more advanced capitalist economy profit is the essential driver of economic behavior. If you can’t get more out than you put in then the venture will be “unprofitable” and you won’t do it. So profit is necessary but the possibility of profit does not inhere within the system. This system needs an external source of money which can be collected as profits both by the industrial economy and by bankers.

Our banking system treats money as a “product” for sale at interest, just as industry produces goods for profit. But banks collectively only distribute an amount of money into the system P, the loan principal. Simultaneously those banks collectively distribute an additional amount of monetary debt into the system I, their interest. The total amount of money required for everyone to repay their principal + interest is P + I, but only P exists in the system.

If new lending stopped adding new money into the equation it would become impossible for everyone to pay their interest and our banking system would fail. Our bank-debt money system operates in parallel with the industrial economic system and suffers the same arithmetic inability to liquidate its prices (P + I) as does the industrial economy.

Douglas advocates a “national dividend” to correct this arithmetic problem, which would work much like Mosler’s “supplementary government workers”. The same effect could be achieved via a guaranteed annual income (GAI) or any other kind of direct government spending of new money into the system that was not first taxed out of the system.

In Mosler’s analysis the residual money in the system would = government “debt” to its CB. But as the economy grew the total “national debt” would have to grow along with it. As we have it now, both public and private debt are contributing to the presence of profit/interest money in our system. Without ever-increasing debt, ongoing profit and interest are not possible.

Mosler quoted several politicians bemoaning the rise of debt. Individuals are stressed by their personal debts. Human nature does not respond well to indebtedness. So there are limits to how long one of these runs of capitalism can go on before we require financial collapse with foreclosures and bankruptcies and attendant large scale writedowns of debts. People can tolerate only so much debt.

The solution offered by Mosler and Douglas, on the other hand, brings its own problems. The same human nature that is debt intolerant also expects people to work for their living and loans to be repaid in kind. If your borrowed money purchases my economic efforts, then I want you to produce some economic efforts for me to purchase with the money I “earned” from you, so you earn the loan repayment money. Borrowed money must be repaid with earned money.

When you throw national dividends or supplementary government work into this psychological mix I fear you unmoor the basis of our economic incentive: if you don’t work you don’t get paid. Payment without work is charity. Even if, as Mosler suggests, you keep the supplementary income (or GAI) at just survival levels so people collecting it will still have incentive to take work that comes available, I am not sure ambitious workers would accept their output being consumed by their indigent neighbors who have been handed, rather than earned, the power of effective demand that is money.

I think the best way to pull off the balance is via government direct spending with consequent constant increase of its debt to its CB. As there gets to be too much “owned” money in the economy gov’t raises taxes to absorb it out and paydown its CB debt. But “national debt” will need to keep rising as long as the national economy is growing. It may or may not be difficult to reeducate policymakers about the post-barter nature of fiat money and government vs. private debt.

In any event, I think a deliberate policy to keep our money system working is better than running it until it crashes then writing it down and starting the next runup.

Posted by JKHNovember 4, 2008 at 8:50 am

Derryl,

Thanks for your response.

I’ve given Mosler’s work only a cursory look, just enough to know I agree with some of his starting points. I’m not sure I’ll end up agreeing with all of it, or any ideological conclusions drawn from it.

I haven’t seen CH Douglas’ writing before. A couple of points seem relatable to Mosler, but the so-called “self-liquidating” problem is not obvious to me, intuitively or analytically. I find it quite counterintuitive. I’d have to spend more time on it. You are clearly much further along on this.

Not being an economist, I’m not familiar with Marxist theory, but my guess is the Douglas analytical framework is connected to it. It’s interesting that the original Canadian Social Credit movement apparently took its name from his work (ref. Wiki).

I’m slightly out of date on the subject of bank capital ratios. Commercial bank capital requirements are based on the translation of nominal assets to risk-adjusted assets, with requirements applying on that transformed basis. The methodologies for investment banks are more or less anchored in value at risk type calculations, which depend on imputed price volatility measures. These methodologies have migrated where appropriate to commercial bank balance sheets, so market volatility does affect the risk adjusted asset measure to some degree. But some of the measures for commercial banks are softer I think, or at least less VAR sensitive. The only measures that really matter in the end are the big aggregates like Tier I and Tier II capital or tangible equity, etc. The requirements are Basel originated with tweaking in some cases by national regulators. And most banks have their own announced targets which often surpass regulatory minimums.

I don’t think we differ at all in our analysis of the scenario you present above.

In particular, I don’t see converting paper notes held by individuals into electronic credits in Fed accounts as a particularly substantive change. A simpler way to make this change, in fact, would be to just acknowledge that the financial system has lost a layer, and let individuals open accounts at the Fed. Sacre bleu!

A comparable conversion might be an obligation to exchange newly-printed currency for worn, cut or damaged bills. This is an administrative responsibility in a sense, but I don’t know that I’d call it a real balance-sheet obligation. Again, corporations may provide for various classes of conversion between equity instruments. There is no way to turn a Google A share into a Google B share, or whatever, but there could be.

I’m not familiar with Mosler’s work – I’ll look at it. I know C.H. Douglas, Ezra Pound’s favorite economist, as a quack, but I don’t remember exactly why and I would not swear to that judgment without checking it. Nor am I confident that Mosler and Douglas are on the same page.

Posted by zanonNovember 6, 2008 at 3:10 am

Mencius: Mosler would also like to see maturities matched (so no-MT). Roll-over risk is just fundamentally useless, no matter what your thoughts are about money, and Mosler would set interest rates at zero permanently so MT doesn’t get you lower rates either.